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Clients' estate plans and individual retirement accounts are due for a review in light of a recent Supreme Court decision that places inherited IRAs into the clutches of creditors in the event of a bankruptcy.

In the case of Clark v. Rameker, the Supreme Court decided unanimously on June 12 against Heidi Heffron-Clark and her husband Brandon C. Clark, finding that an IRA Ms. Clark inherited directly from her deceased mother in 2000 isn't eligible for protection from creditors. The couple had filed for Chapter 7 bankruptcy back in 2010, and at that time identified the inherited IRA — then valued at $300,000 — as exempt from the bankruptcy estate.

The bankruptcy trustee and creditors of the couple's estate had pushed back against the claimed exemption, arguing that the money in the inherited IRA was not considered “retirement funds.”

The case eventually went to the Supreme Court, where Justice Sonia Sotomayor pointed out in the unanimous opinion three areas where the interests of traditional IRA holders differ from inherited IRA holders:

1. Holders of inherited IRAs cannot invest additional money into the account, whereas those with traditional and Roth IRAs can do so.

2. The tax code requires inherited IRA holders to withdraw the money from the account, either taking all of the money in the IRA within five years after the death of the owner or taking minimum annual distributions each year.

3. Inherited IRA holders may also take all of the money out at any time and for any purpose without penalty. Roth and traditional IRA holders, meanwhile, are subject to a 10% penalty for withdrawals before age 59.5.

Those three characteristics led the court “to conclude that funds held in such accounts are not objectively set aside for the purpose of retirement,” Justice Sotomayor wrote.

The decision is giving planners pause, and it's creating a lot of conjecture in the planning community. For one thing, there are different state laws on how inherited IRAs are treated in light of a bankruptcy, and eight states protect them from creditors: Texas, Florida, Ohio, Missouri, Alaska, North Carolina, Idaho and Kansas.

“What [the case] clearly means is that if you want to protect an IRA for a child, the only way to do that is to leave the IRA to a trust,” said Robert S. Keebler, partner with Keebler and Associates.

Going forward, strategies ought to consider income tax issues and asset protection. Mr. Keebler recommends using an accumulation trust, so the trustee can opt to hold onto the funds and not make distributions. On the asset protection front, there's the discretionary trust, one that isn't subject to requirements that the money be used for health, education, support and maintenance. Generally, the court won't be able to force distributions to be made from this trust, in the event creditors and other parties hope to seize the funds, Mr. Keebler said.

Phil Kavesh, an estate planning attorney, noted that another tool to consider is the IRA inheritance trust, which the IRS has permitted through a private letter ruling. The payments coming out of the IRA can be stretched to the life expectancy of the beneficiary, while the trust provides protection in the event of divorce or bankruptcy.

For trusts, the beneficiary of the IRA should be the trust itself and not the child or spouse directly.

When it comes to spouses, a spouse who inherits an IRA from a deceased partner can roll the money over into her own account. “As a result of the opinion, survivors have something to think about. Do they inherit, or do they rollover?” said Aaron Flinn, an attorney with Waller Lansden Dortch & Davis.

But beware: Ed Morrow, an estate planning lawyer and national wealth specialist with Key Private Bank, noted in a June 16 blog post for the Leimberg Information Services Inc. newsletter that “once a spouse rolls over the IRA to his or her own, it is unclear whether and how the bankruptcy code will protect the funds.”

Though the bankruptcy code permits spousal rollovers to continue to be qualified, there's the question of whether the IRA loses its qualification as a retirement fund once it's inherited. Mr. Morrow also warns that in most states a spousal rollover by a debtor could be considered a fraudulent conversion of non-exempt assets, such as the inherited IRA, to an exempt asset, or the spouse's own IRA.

Regardless of the tack advisers and clients decide to take, first and foremost they need to have a conversation to discuss IRAs and beneficiary designations, particularly if a client has recently inherited an IRA. “It's incredibly important for financial advisers to get the lawyers and CPAs involved immediately after someone's death before taking action,” Mr. Keebler said.

A previous version of this story incorrectly stated that seven states protect inherited IRAs from creditors. Inherited IRAs are actually protected in eight states.

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